Alas, as I reviewed my holdings toward the end of last year, I discovered I owned two mutual funds that purported to be actively managed but appeared to hold a disproportionate share of its investments in holdings that are identical to the those of its benchmark index. Like the Nathaniel Hawthorne’s Puritan character, Hester Prynne, give me a scarlet letter too—in my case, the letter C for closet investor.

I initially learned about my deleterious investment actions in an obscure journal—Banking & Financial Services Policy Report. You’ll probably have to access it via a business periodical database from your public library. The periodical’s April 2017 edition contains an article entitled, “Overpaying for Closet Index Funds: A Legal Analysis.” The authors’, Professors K.J. Martijn Cremers and Quinn Curtis, research found that more than 10 percent of US mutual fund assets currently could be categorized as closet index funds. Such funds tend to be poor investment choices because the investors incur higher fees for a substantially similar portfolio that a low cost passively managed fund offers. Their previously published work going back almost a decade contain similar warnings of the dangers of these funds.

Think about this for a moment. According to the Investment Company Institute, mutual funds at the end of 2016 held $16 trillion in assets. If but 10% of those assets are in closet indexers’ hands, that represents $1.6 trillion of investors’ cash subject to higher fees and lacking outperformance.

Tools For Determining If You Are a Closet Index Buyer

Fortunately, Cremers and Curtis have identified two tools - active share and active fee - that investors can use to determine if their money is among that $1.6 trillion. Active share measures the proportion of a fund’s assets invested differently from its benchmark. The authors use a threshold of less than 60 percent active share to indicate that a fund is a closet indexer. The authors add that closet indexers are mostly found among large cap funds.

Active fee is a fund’s expense ratio adjusted for its active share, attributing the average index fund fee to the inactive portion of the fund’s portfolio. Active fee indicates the fees paid for the part of the portfolio that is in fact actively managed. The graphic below, courtesy of Alpha Architect is Cremers’ and Curtis’s formula for active share:

Other tools such as R-squared and tracking error can also be useful in identifying closet index funds. R-squared or correlation measures how different fund returns are from the returns of the fund's benchmark. A fund with an R-squared of 100 matches an index exactly, while one with an R-squared of 50 has returns that are only half explained by the index.

Actively managed funds should have a low R-squared, because portfolio managers are supposedly paid to make index-beating bets. But a paper published by Professor Yakov Amihud of New York University's Stern School of Business found that the median fund has an R-squared of 93%.

Tracking error is the difference between a fund's performance and its benchmark's performance. Expressed as a percentage, a low tracking error suggests an active fund's manager is mimicking the index. The most common method is to take the standard deviation of the difference in the fund’s and index’s returns over time.

I Confess

Table 1 is evidence of my closet index investing. Standard benchmark index, three-year R-squared and expenses are from Morningstar.com as is the information needed to compute tracking error. Active share can be obtained by going to Professor Cremers' Homepage | Active Share. The site lists many but not all mutual funds. Active fee is derived from a combination of information from Cremers' site and Morningstar. The benchmark ETF was of my choosing based on two factors--its alignment with the standard benchmark and low expense.

American Funds Fundamentals Invs C’s (MUTF:AFICX) active share, below 60%, suggests the closet indexing nature of the fund. Ivy Small Cap Growth C’s (MUTF:WRGCX) active share, in contrast shows significant difference from its benchmark. However, Morningstar’s Jeffrey Schumacher cautions that active share only measures the proportion of a fund’s assets invested differently from the benchmark. It is notably silent on the prudence of those divergences from the index. In other words, a high active share doesn’t translate into outperformance as the data in Table 2 shows.

Ticker

2015 Fund Return vs Its Low Cost ETF with Same Benchmark

2016

2017

3-Year Fund Return vs Its Low Cost ETF

AFICX

1.18%

-0.31%

0.54%

0.7%

WRGCX

1.68%

-8.8%

8.2%

0.8%

Table 2 – Three Year Performance AFICX & WRGCX

Longer term, however, Professor Cremers found that funds with the highest active share during the period 1980 to 2003 beat their benchmark index by an average of 1.39 percentage points per year, while those with the lowest active shares produced returns that lagged their benchmark by an average of 1.41 percentage points.

Active fees for both my funds approach and even surpass the standard asset-based 2% fees of hedge funds! R-squared also reveals my funds’ close match to its index.

You May Have to Drill Down Deeper in Your Portfolio Review

Active share and R-squared don't tell the whole story. Adding tracking error to your analysis can produce a more complete picture. For example, AFICX’s high tracking error, despite its high level of active share, implies active positioning of some kind relative to the benchmark. Digging deeper into Morningstar’s database, I found that about 20% of the fund’s holdings are in non-US stocks. (Remember Morningstar’s standard benchmark index for this fund in the S&P 500.)

A 2013 Morningstar article puts Professors Cremers' and Curtis's work into actionable advice for investors wishing to avoid the closet indexers. Active share, tracking error and other tools can provide context, but they shouldn't be the basis for decisions by themselves. “Investors still need to do their homework and look into what might be driving a given fund's active share or tracking error. As always, understanding what's behind a data point remains critical in determining whether a given fund is the best fit for the job.” That understanding, of course, includes one’s satisfaction that Morningstar’s or another data provider’s standard benchmark is accurate and relevant.

In my case, having looked at the data compiled in the tables above, I was struck by three data points: The hedge fund-like active fees I’m paying; cheaper alternatives are available to include those that can provide me with exposure to non-US markets that, frankly, I wasn’t aware AFICX provided; the less than stellar three-year performance of my two mutual funds. So I sold them.

More Examples

Table 3 presents without analysis (except to note the astronomical active fee figure for Great-West S&P 500 Index Investor (MUTF:MXVIX)), a sampling of a few S&P 500-benchmarked funds simply to note the differences that can exist within different investors’ portfolios that contain mutual funds.

Recommendation

As this new year unfolds, review your mutual fund holdings looking at not just one or two but all the tools described in this article. And like I did for AFICX, dig deeper if needed. If you find that you too are wearing the Scarlet C, sell those funds!

Disclosure:I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.